The Intellectual Fallacy Of Central Bank Financial Strength

There is an article in this month’s ECB Bulletin titled “Central bank balance sheet expansion and financial strength in crisis times: the case of the Eurosystem”. It is an extraordinary display of cant, nonsense and false assertions; in fact, it is almost Orwellian, as in 1984. Please wade through the following excerpts, and then I will comment:

“The implementation of monetary policy is inevitably associated with financial risk because it involves the provision of central bank money against assets or collateral from private agents. If a central bank is perceived to be taking excessive risk, its credibility and the public’s perception of its ability to deliver on its mandate may be affected. 

"Both in normal and in crisis times, central banks must preserve their financial strength, which means that they must always have sufficient financial resources available over time to conduct monetary policy in an independent manner, and hence deliver their policy objectives in all circumstances.  What matters in ensuring the credibility of the central bank is its financial strength across time.

“The ECB treaty prohibits monetary financing. These provisions preclude the monetising of sovereign debt. Through promoting price stability in the long term, these provisions indirectly contribute to the financial health of the Eurosystem’s balance sheet.

“The central bank’s stand-alone financial strength reinforces credibility in its capacity to always deliver on its mandate while avoiding exposure to political pressures. This helps to anchor expectations among the general public and financial market participants that the central bank is in a position to effectively deliver on its mandate and that its monetary policy decisions will not be unduly constrained by concerns about financial resources.”

--ECB Monthly Bulletin, September 2013

Let’s parse these words. Note that the tone is didactic, from “on high”, as opposed to scientific. No evidence is adduced in support of the following four palpably false hypotheses:

1. To maintain confidence and credibility, central banks must maintain a high level of standalone financial strength.

2. Central banks must always have sufficient financial resources available over time to conduct monetary policy in an independent manner, and hence deliver their policy objectives in all circumstances.  

3. The ECB’s unwillingness to engage in QE (“monetary financing”) contributes to the financial health of the Eurosystem’s balance sheet.

4. The ECB’s standalone financial strength helps to anchor expectations that monetary policy will not be constrained by concerns about financial resources.

In a nutshell: A principal policy objective of a fiat money central bank should be its standalone financial strength.

Where did this shibboleth come from? Please name the economist, in any country. This bogus platitude can be found in no economics textbook written since the end of the gold standard. It was pulled out of thin air, and what I have called “Commercial Bank Thought”, the earnest belief system of those who think that because they understand commercial banking, they must be experts at central banking. One can work for a commercial bank for decades and never learn anything about monetary policy--in fact the correlation is negative. Commercial banking is about making and collecting loans. Central banking is about delivering growth with moderate inflation. Those two Venn Diagrams don’t touch. Commercial banks (private sector, profit-seeking enterprises) inadvertently, unintentionally and unknowingly act as vectors of central bank policy.

Now, I will concede that when the Fed is asked to lend dollars to foreign central banks, it must consider their ability to pay the dollars back. But normally, central banks don’t borrow from each other. It’s a tangential activity. What central banks actually do is manage the money supply by adding or withdrawing liquidity from the banking system. That means either buying bonds with newly printed currency, or selling bonds from  portfolio.

The only actors who have credit exposure to the central bank are commercial banks who keep their liquidity reserves there. Do they worry about the Fed’s standalone financial strength? No. Here’s the crucial point: the reason why JP Morgan does not have a team of analysts running the numbers on the NY Fed (where it has a lot of money on deposit) is because the NY Fed prints dollars. The NY Fed can’t run out of dollars.

Now let’s turn to other holders of dollar claims, such as the People’s Bank of China. Does the PBoC have analysts studying the Fed’s balance sheet? No, because the PBoC knows that the Fed prints dollars just as it prints RMB. There is no credit risk associated with its claims on the Fed. (The Treasury, yes, but the Fed, no.)

Bogus hypothesis: “Central banks must always have sufficient financial resources available over time to conduct monetary policy.” What does this mean? When it comes to buying things, they print money, so that is not a constraint. Now they do have to sell assets from time to time to mop up liquidity. What if they run out of bonds to sell? Then they can sell their own bonds. Not only does a fiat money central bank not require capital, it doesn’t require assets, since it can issue its own bonds.

Bogus hypothesis: “The ECB’s unwillingness to engage in QE contributes to the financial health of the Eurosystem’s balance sheet.” What the ECB is saying is that, because it won’t buy Club Med government bonds, it is maintaining the euro’s credibility by protecting it from Club Med government credit risk. The euro is backed by good Nordic assets, not dodgy Latin assets. The credibility of the euro is supported by the market’s confidence that the ECB can survive a collapse of Southern Europe. Indeed, the credibility of the euro may require the collapse of Southern Europe, which is a small price to pay for credibility.

I recently suggested that Draghi is a hired gun. His employment contract specifies price stability, and that’s what he’s delivering. I have also said that Draghi has a secret contempt for the corrupt and profligate Italian political class, and that he hopes that Italy can be reformed by austerity and deflation. Maybe, who knows? He doesn't talk to me. But I would like to think that Draghi is a man of integrity and charity, and not merely a mercenary of the Bundesbank.

So I ask myself: Did Draghi read this article, or was it written by the Bundesbank and shoved into the Bulletin? Why did he allow it to be published, when he knows that it is utter nonsense?

At some point, when X+1 millions of Europeans are out of work, I would hope that Draghi will have the courage to be the St. Thomas Moore to Jens Weidmann's King Henry VIII and say: “I can no longer support your policies. I will do what I see fit, and it will be up to you to try to stop me”.